The following is the Executive Summary of a book released on September 18. “In Northern Light: Lessons for America from Canada’s Fiscal Fix, Brian Lee Crowley, Managing Director of the Ottawa-based Macdonald-Laurier Institute, and Nashville-based Robert P. Murphy, Principal at Consulting By RPM, conclude all American office holders are fully aware of the tough medicine needed to heal a fiscal crisis that is only getting worse. But they fear the political consequences.”

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Introduction

The United States now finds itself in a fiscal crisis that is quickly spinning out of control. If present trends continue, the federal debt will soon reach what many economists believe is the danger zone of 90 percent of GDP, while entitlement spending and interest costs will eventually consume virtually the entire federal budget.

The ultimate solution to this problem is at once obvious and difficult: The federal government must cut spending, and then restrain its growth until tax receipts have surpassed it. Only by running a string of actual budget surpluses can the debt burden quickly be brought under control. Eventually the vicious cycle of a debt snowball can be replaced by the virtuous cycle of budget surpluses leading to tax relief, which in turn will promote even stronger economic growth and a healthier fiscal position for the government.

Although the solution to the fiscal crisis is clear, it will be politically difficult to implement. Yet those who say it is impossible need to review recent history. Canada faced a fiscal crisis in the mid-1990s that in many respects was more severe than the one facing the United States today. The Canadians found the will to cut spending and federal employment by at least a tenth over the course of a few short years. They produced their first balanced budget in decades, and quickly emerged from their fiscal hole to become a model of fiscal discipline. Finally, and perhaps most importantly, the Canadian episode of fiscal austerity went hand-in-hand with continued
economic growth and falling unemployment rates.

The United States’ Unsustainable Fiscal Trajectory

Before offering prescriptions to cure the US government’s fiscal problems, we need to first accurately diagnose the condition. Across several criteria, the federal government has grown too big and must be scaled back.

Federal Spending

Since the 1970s there has been growth across all major components of federal spending. The massive surge in federal spending cannot be blamed simply on “mandatory” spending programs such as Medicare, Social Security, and interest on the federal debt, nor can it even be blamed on military spending, which many would view as necessary because of the US role in world affairs. No, even “nondefense discretionary” spending has steadily risen throughout the decades.

Federal Budget Deficits and Debt

The federal budget deficit represents the amount by which outlays exceed receipts; it is how much the government must borrow in a given year to meet its spending commitments.

The federal debt held by the public escalated rapidly due to the large budget deficits since the onset of the recent financial crisis, hitting over twothirds of GDP by the end of fiscal year (FY) 2011. Even if the currently planned, if unrealistic, budget and tax reforms are implemented, the CBO projects that the federal debt will rise to over three-quarters of GDP by 2014, before turning down. If Congress takes the easy path on these issues – as it has in the past – then the CBO projects the federal debt will exceed annual US
GDP by the year 2024.

Federal Entitlements

One of the main difficulties in turning around the long-term fiscal condition of the United States government is the unsustainable current structure of entitlement programs, in particular Social Security and Medicare. From a unified budgetary perspective (disregarding IOUs issued by the Treasury to other parts of the US government), the latest Trustees Report estimates that the Hospital Insurance (HI), Supplemental Medical Insurance (SMI), and Old Age, Survivors, and Disability Insurance (OASDI) programs – constituting what the public knows as Medicare and Social Security – over the next 75 years will have a massive shortfall in anticipated payroll contributions relative to expected beneficiary payments. If the government kept a fund to cover the difference between what it takes in for these programs and what it needs to pay out for them, they would currently need a staggering $38.6 trillion.

The Centralization of Federal Power

Not only has the federal government grown faster than the private sector, but it has also grown relative to state and local governments. In other words, the US trend toward bigger government has gone hand in hand with a trend toward more centralized government in Washington, D.C.

The United States clearly finds itself in a fiscal crisis, brought on by excessive growth in government. Fortunately, there is a way out, as the Canadian example from the mid- to late-1990s demonstrates.

The Amazing Canadian Fiscal Turnaround

In the mid-1990s Canada was in a full-scale fiscal crisis. The federal government had run substantial budget deficits consistently for 20 years; Ottawa’s indebtedness was reaching crisis levels; and a third of all federal government revenue was being used simply to pay interest on the debt. The status quo had become unsustainable. Without significant fiscal reform, Canada was at risk of hitting the “debt wall” – when investors stop financing government debt.

The federal government was caught in an unsustainable cycle: Higher interest costs were leading to higher deficits, which required more borrowing, which further increased interest costs as investors demanded higher returns to compensate them for the increased riskiness of lending to the Canadian government.

The 1995 Budget – Ottawa Changes Course

After some lackluster reforms that were not commensurate with the scale of the problem, the Canadian government became serious when the Mexican peso collapsed in December 1994, and a January 1995 Wall Street Journal article argued that the Canadian government was near bankruptcy.

The catalyst came when the ruling Liberals delivered their austere budget on February 27, 1995. This document set in motion a fundamental change from the status quo and ultimately became a defining moment in Canada’s fiscal history. In his budget speech, finance minister Paul Martin boldly stated the new direction for the government and the government’s almost sole
focus: Getting the debt and deficit under control.

The budget plan included a host of concrete actions such as

a substantial reduction in the size of the federal government – spending and employees – to reduce the deficit;

reform of government programs with an increased focus on efficiency;

reform and a reduction of the employment insurance (EI) program;

substantial reductions in business subsidies; and

restructured and reduced provincial transfers.

Ottawa Cuts Federal Government Spending and Employment

The 1995 federal budget proposed cutting billions in spending, a cumulative reduction approaching a tenth of the budget over the first two years. In addition, the budget proposed reducing federal government employment by almost a sixth once fully implemented.

Getting Government Right – Program Review

The proposed reductions in program spending in the 1995 budget were largely the result of the program review. Ministers in every government department put their departments under the microscope. In particular they applied six tests to everything their departments did:

Does it serve the public interest?

Is government involvement necessary?

Is it an appropriate federal role?

What is the scope for public sector/private sector partnerships?

What is the scope for increased efficiency?

Is it affordable?

The program review led to a significant structural change in the federal government’s involvement in the Canadian economy. Major reforms included:

Dramatic changes in the federal government’s involvement in large parts of Canada’s transportation system.

A complete change to the federal government’s approach to agriculture, including a move away from an emphasis on income support to income stabilization.

A massive reduction in the federal government’s involvement in the business sector, including a proposed 60 percent cut in subsidies to businesses.

A change in the way in which departments delivered services to Canadians, including an increased focus on efficiency.

A significant source of savings was the move away from federal transfers based on federal-provincial cost-sharing programs to a block-grant approach in which the amount transferred by the federal government to the provinces did not depend on provincial spending. This decentralization of power both contained spending and allowed for experimentation and innovation.

Spending Cuts Far Outweighed Tax Hikes

Finance minister Paul Martin claimed in his 1995 budget speech that the government “must focus on cutting spending – not raising taxes.” It didn’t quite turn out that way, as the new budget did raise some taxes. Even so, for the next two years, spending reductions were more than four and a half times larger than revenue increases.

After the Reforms: Let the Good Times Roll

The importance of the 1995 fiscal reforms can scarcely be exaggerated. The size of the federal government shrank significantly, balancing its budget within three years, which yielded the first surplus the Canadian government had enjoyed in almost a quarter century. Canada’s federal government transformed itself from a fiscal basket case to the envy of the industrialized
world.

Equally as important as the nominal reductions in outlays is how government spending and revenues compared with the economy. All told, federal government spending (program spending plus interest payments) fell by 17 percentage points of GDP over two years.

The federal government ran 11 consecutive budget surpluses beginning in 1997/98. Consistent surpluses meant a reduction in the dollar-value of federal debt. With the federal government paying down debt and the economy expanding, the total public debt plummeted from 80.5 percent of GDP in 1997/98 to 45 percent a decade later.

The Canadian experience shows that with courageous leadership and sound policy, even a serious fiscal crisis can be reversed in just a few short years. US policymakers should pay close attention to the lessons from Canada.

Canada’s Lessons for America

Before drawing specific lessons for the United States, it is useful to assess just how significant the Canadian reforms were. Whether we look at absolute federal spending in dollars, spending as a percentage of the economy, deficits, or total federal debt, the actual Canadian response to their fiscal crisis was far more austere than what has been proposed in the BowlesSimpson and even the 2013 House Budget Resolution (“Paul Ryan plan”) proposals.

Lessons from Canada: Getting Spending Right

The single most important lesson to draw from the Canadian success is the need for sharp and immediate spending cuts. To translate the Canadian experience to the United States would imply a cut of $66 billion in the first year of reform, followed by an additional $262 billion cut in the second year of reform. By the third year – if the United States were to continue following the Canadian example – total non-interest spending could resume growing again, but only at a restrained pace.

To achieve such aggressive cuts in federal spending, every program must come under review. There is simply no way around this. Cuts in absolute spending would be necessary across the major CBO budget categories in order to mirror the Canadian approach to total program spending. Likewise, a comparable drawdown in federal employment would mean reducing federal government payrolls by 378,000 over the course of three years.

Lessons from Canada: Getting the Debt Under Control

The Canadian experience shows that a quick move to budget surpluses, coupled with economic growth, can sharply reduce debt as a share of GDP. Fortunately, if the United States matched the Canadian example on spending, then the budget deficit would disappear in less than a decade, under both scenarios of revenue growth put out by the CBO.

If revenue grew according to the CBO baseline forecast, and if total US government spending followed the Canadian example, then over the first 10 years of reform, the debt/GDP ratio would fall from about three-quarters in FY 2012 to just a third by FY 2022.

Lessons from Canada: Entitlement Reform

Absent major demographic changes, there is no way to continue with present tax and benefit schedules earmarked for these dedicated programs. Although the entitlement situation in the United States presents unique difficulties, the Canadian approach to social insurance at the federal level provides some instructive lessons.

First and most obvious, the Canadians significantly increased the tax rate on earnings earmarked for the Canadian Pension Plan. In addition to the taxrate increase, changes to benefit schedules were also introduced, including reduced eligibility for disability benefits, a cap on death benefits, and a change in the formula for individual benefit payments.

Yet there are other lessons to be drawn from Canada’s approach to entitlements. Despite the tax-rate increase, the CPP tax is much less onerous than the Social Security tax on US workers and employers, in terms of both percentage and the amount of income taxable.

In Canada, the federal pension plan does not assume nearly the same role in retirement planning as Social Security has come to mean in the United States. For starters, the benefit can only be one-quarter of pensionable earnings. To handle cases of seniors deemed to have an inadequate income, there is a dedicated, means-tested program, namely the Guaranteed Income Supplement (GIS) program, financed out of general tax revenues. Finally, Canada has a federal Old Age Security (OAS) program, which is also paid out of general revenues and is not tied to a recipient’s work history.

The interesting feature of the Canadian approach is that it breaks up the functions handled in the United States by Social Security (and to some extent, Medicare and Medicaid) into separate programs. US policymakers should consider something similar as part of longer-term reform.

Lessons from Canada: Decentralization

The final lesson from Canada is its move to a smaller role for the federal government. Starting in the early 1970s the two countries spent similar shares of GDP on their respective federal governments. Yet from 1996 onward, a widening gap developed. Clearly, if the United States is to mirror the Canadian approach to fiscal reform, the federal government needs to drastically reduce its role in the economy.

Lessons from Canada: Managing the politics of reform

Perhaps the most important lesson of all from Canada isn’t what they did, but rather how they did it. We can distill six political lessons from Canada’s reform program of the 1990s.

Focus on reform is required across party lines. Progress on the deficit only became possible when Canadian parties ceased to treat it as a matter of partisan contention, but rather of vital national interest.

Politicians can’t play favorites with reform, carving out exemptions for their friends and socking it to their opponents. If fixing the deficit is a challenge for the nation, then the whole nation has to be called upon to contribute.

Time is of the essence. Proceeding piecemeal instead of broadly and decisively undermines the wide social consensus necessary, and would have delayed the handsome pay-off that Canadians enjoyed once they had broken the back of the deficit.

Reforms must be carried out intelligently and humanely. Canadians accepted that the policy was fair, and that mattered a great deal to them.

A simple, easy to understand target is crucial to maintaining public support. When Canada set a goal to eliminate the deficit, the nation eagerly awaited each budget and took great pride in reaching that goal.

If you get all the other elements right, the supposedly insurmountable institutional obstacles to reform often prove to be paper tigers.

What American politicians most need to know from the Canadian experience is that thoughtful reform, cleverly managed, paid handsome political dividends: The Liberal government of Prime Minister Jean Chrétien that introduced these changes was handily re-elected in 1997 and 2000, and reforming provincial governments in places like Alberta and Saskatchewan
enjoyed similar success.

Conclusion

The United States achieved a budget surplus as recently as the Clinton years. Back then, thanks to tax receipts buoyed by a strong economy, eliminating the deficit only required slowing spending growth. However, the current US situation is worse, and the fiscal hole is deeper. Genuine reductions in federal government spending and employment are necessary. As politically difficult as these reforms may be, they are not impossible. Canadians did it in the mid-1990s, and so can Americans today. The payoff was a quick turnaround in the government’s fiscal position without hampering economic growth, and lower taxes in the longer-run that buoyed future growth.